CHAPTER 04—ANALYSIS OF FINANCIAL STATEMENTS

Multiple Choice: Conceptual

51. Which of the following would, generally, indicate an improvement in a company's financial position,
holding other things constant?
a. The TIE declines.
b. The DSO increases.
c. The quick ratio increases.
d. The current ratio declines.
e. The total assets turnover decreases.
ANSWER: C

52. A firm wants to strengthen its financial position. Which of the following actions would increase its current
ratio?
a. Reduce the company's days' sales outstanding to the industry average and use the resulting cash
savings to purchase plant and equipment.
b. Use cash to repurchase some of the company's own stock.
c. Borrow using short-term debt and use the proceeds to repay debt that has a maturity of more than
one year.
d. Issue new stock, then use some of the proceeds to purchase additional inventory and hold the
remainder as cash.
e. Use cash to increase inventory holdings.
ANSWER: d

54. Companies E and P each reported the same earnings per share (EPS), but Company E's stock trades at a
higher price. Which of the following statements is CORRECT?
a. Company E probably has fewer growth opportunities.
b. Company E is probably judged by investors to be riskier.
c. Company E must have a higher market-to-book ratio.
d. Company E must pay a lower dividend.
e. Company E trades at a higher P/E ratio.
ANSWER: e

55. Which of the following statements is CORRECT?

a. Borrowing by using short-term notes payable and then using the proceeds to retire long-term debt
is an example of "window dressing." Offering discounts to customers who pay with cash rather
than buy on credit and then using the funds that come in quicker to purchase additional inventories
is another example of "window dressing."
b. Borrowing on a long-term basis and using the proceeds to retire short-term debt would improve the
current ratio and thus could be considered to be an example of "window dressing."
c. Offering discounts to customers who pay with cash rather than buy on credit and then using the
funds that come in quicker to purchase fixed assets is an example of "window dressing."
d. Using some of the firm's cash to reduce long-term debt is an example of "window dressing."
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 e."Window dressing" is any action that does not improve a firm's fundamental long-run position and
thus increases its intrinsic value.
ANSWER: b

56. Casey Communications recently issued new common stock and used the proceeds to pay off some of its
short-term notes payable. This action had no effect on the company's total assets or operating income. Which of
the following effects would occur as a result of this action?
a. The company's current ratio increased.
b. The company's times interest earned ratio decreased.
c. The company's basic earning power ratio increased.
d. The company's equity multiplier increased.
e. The company's total debt to total capital ratio increased.
ANSWER: a

57. A firm's new president wants to strengthen the company's financial position. Which of the following actions
would make it financially stronger?
a. Increase accounts receivable while holding sales constant.
b. Increase EBIT while holding sales and assets constant.
c. Increase accounts payable while holding sales constant.
d. Increase notes payable while holding sales constant.
e. Increase inventories while holding sales constant.
ANSWER: b

60. If a bank loan officer were considering a company's loan request, which of the following statements would
you consider to be CORRECT?
a. The lower the company's inventory turnover ratio, other things held constant, the lower the interest
rate the bank would charge the firm.
b. Other things held constant, the higher the days sales outstanding ratio, the lower the interest rate the
bank would charge.
c. Other things held constant, the lower the total debt to total capital ratio, the lower the interest rate the
bank would charge.
d. The lower the company's TIE ratio, other things held constant, the lower the interest rate the bank
would charge.
e. Other things held constant, the lower the current ratio, the lower the interest rate the bank would
charge the firm.
ANSWER: c

62. A firm wants to strengthen its financial position. Which of the following actions would increase its quick
ratio?
a. Offer price reductions along with generous credit terms that would (1) enable the firm to sell some of
its excess inventory and (2) lead to an increase in accounts receivable.
b. Issue new common stock and use the proceeds to increase inventories.
c. Speed up the collection of receivables and use the cash generated to increase inventories.
d. Use some of its cash to purchase additional inventories.
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 e. Issue new common stock and use the proceeds to acquire additional fixed assets.
ANSWER: a

66. Which of the following statements is CORRECT?

a. If Firms X and Y have the same P/E ratios, then their market-to-book ratios must also be equal.
b. If Firms X and Y have the same net income, number of shares outstanding, and price per share, then
their P/E ratios must also be the same.
c. If Firms X and Y have the same earnings per share and market-to-book ratio, they must have the
same price/earnings ratio.
d. If Firm X's P/E ratio exceeds that of Firm Y, then Y is likely to be less risky and/or be expected to
grow at a faster rate.
e. If Firms X and Y have the same net income, number of shares outstanding, and price per share, then
their market-to-book ratios must also be the same.
ANSWER: b
RATIONALE: No reason for a to be true. b must be true, as EPS and P will be equal. No reason for c to be true.
Wrong, because high risk and low growth lead to low P/Es. No reason for e to be true.

68. You observe that a firm's ROE is above the industry average, but both its profit margin and equity multiplier
are below the industry average. Which of the following statements is CORRECT?
a. Its total assets turnover must be above the industry average.
b. Its return on assets must equal the industry average.
c. Its TIE ratio must be below the industry average.
d. Its total assets turnover must be below the industry average.
e. Its total assets turnover must equal the industry average.
ANSWER: a
RATIONALE: Thinking through the DuPont equation, we can see that if the firm's PM and equity multiplier are
below the industry average, the only way its ROE can exceed the industry average is if its total
assets turnover exceeds the industry average. The following data illustrate this point:

ROE = PM × TATO × Eq. Mult. ROA

Firm 30% 9% 2.0 1.67 18%
Industry 25% 10% 1 2.50 10%

The above demonstrates that a is correct, and that makes d and e incorrect. Now consider the
following:
NI/Assets = NI/Sales × Sales/Assets
ROA = PM × TATO

If its ROA were equal to the industry average, then with its low equity multiplier (hence lower
financial leverage and use of less debt) its ROE would also be below the industry average. So b
is incorrect. With lower debt (since equity multiplier is less than industry average), its interest
charges should also be low, which would increase its TIE ratio, making c incorrect.

69. Companies HD and LD are both profitable, and they have the same total assets (TA), total invested capital,
sales (S), return on assets (ROA), and profit margin (PM). Both firms finance using only debt and common
equity. However, Company HD has the higher total debt to total capital ratio. Which of the following statements
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is CORRECT?
a. Company HD has a lower total assets turnover than Company LD.
b. Company HD has a lower equity multiplier than Company LD.
c. Company HD has a higher fixed assets turnover than Company LD.
d. Company HD has a higher ROE than Company LD.
e. Company HD has a lower operating income (EBIT) than Company LD.
ANSWER: d
RATIONALE: Rule out all answers except d because they are false. Alternative answer using the DuPont
equation:
ROE = PM × TATO × Eq. multiplier
ROE = NI/S × S/TA × TA/Equity
The first two terms are the same, but HD has a higher equity multiplier due to its higher debt,
hence higher ROE.

70. Taggart Technologies is considering issuing new common stock and using the proceeds to reduce its
outstanding debt. The stock issue would have no effect on total assets, the interest rate Taggart pays, EBIT, or
the tax rate. Which of the following is likely to occur if the company goes ahead with the stock issue?
a. The ROA will decline.
b. Taxable income will decline.
c. The tax bill will increase.
d. Net income will decrease.
e. The times-interest-earned ratio will decrease.
ANSWER: c
RATIONALE: a is false because reducing debt will lower interest, raise net income, and thus raise ROA. b is
false for the above reason. c is true for the above reason. d is false The TIE will increase because
interest charges will be smaller due to less debt.

71. Which of the following statements is CORRECT?

a. The ratio of long-term debt to total capital is more likely to experience seasonal fluctuations
than is either the DSO or the inventory turnover ratio.
b. If two firms have the same ROA, the firm with the most debt can be expected to have the
lower ROE.
c. An increase in the DSO, other things held constant, could be expected to increase the total
assets turnover ratio.
d. An increase in the DSO, other things held constant, could be expected to increase the ROE.
e. An increase in a firm's total debt to total capital ratio, with no changes in its sales or
operating costs, could be expected to lower its profit margin.
ANSWER: e
RATIONALE: a. Sales fluctuations would have more effects on the DSO and S/Inventory ratios.
b. ROE = ROA × Equity multiplier, so the more debt, the higher ROE for a given ROA.
DSO = Receivables/Sales per day. With sales constant, an increase in DSO would
c.
mean an increase in receivables, hence a decline, not a rise, in the TATO (S/TA).
An increase in the DSO might increase or decrease ROE, depending on how it
d.
affected sales and costs.
e. More debt would mean more interest, hence a lower NI, given a constant EBIT. This
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 would lower the profit margin = NI/Sales.

79. Which of the following statements is CORRECT?

a. In general, if investors regard a company as being relatively risky and/or having relatively poor
growth prospects, then it will have relatively high P/E and M/B ratios.
b. The basic earning power ratio (BEP) reflects the earning power of a firm's assets after giving
consideration to financial leverage and tax effects.
c. The "apparent," but not necessarily the "true," financial position of a company whose sales are
seasonal can change dramatically during a given year, depending on the time of year when the
financial statements are constructed.
d. The market/book (M/B) ratio tells us how much investors are willing to pay for a dollar of
accounting book value. In general, investors regard companies with higher M/B ratios as being
more risky and/or less likely to enjoy higher future growth.
e. It is appropriate to use the fixed assets turnover ratio to appraise firms' effectiveness in managing
their fixed assets if and only if all the firms being compared have the same proportion of fixed
assets to total assets.
ANSWER: c

80. Walter Industries' current ratio is 0.5. Considered alone, which of the following actions would increase the
company's current ratio?
a. Borrow using short-term notes payable and use the cash to increase inventories.
b. Use cash to reduce accruals.
c. Use cash to reduce accounts payable.
d. Use cash to reduce short-term notes payable.
e. Use cash to reduce long-term bonds outstanding.
ANSWER: a
RATIONALE: The following equation can be used. If you add equal amounts to the numerator and
denominator, then if Orig CR = or > 1.0, CR will decline, but if Orig CR < 1.0, CR will increase.
Obviously, if you add to one but not the other, CR will increase or decrease in a predictable

manner. We see that a is correct.

Example:
Original Plus New Old New
CA/CL $1 CA/CL CR CR
1
0.50 0.67 CR rises if initial CR is less than 1.0
1

81. Safeco's current assets total to $20 million versus $10 million of current liabilities, while Risco's current
assets are $10 million versus $20 million of current liabilities. Both firms would like to "window dress" their
end-of-year financial statements, and to do so they tentatively plan to borrow $10 million on a short-term basis
and to then hold the borrowed funds in their cash accounts. Which of the statements below best describes the
results of these transactions?
a. The transactions would improve Safeco's financial strength as measured by its current ratio
but lower Risco's current ratio.
b. The transactions would lower Safeco's financial strength as measured by its current ratio but
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 raise Risco's current ratio.
c. The transactions would have no effect on the firm' financial strength as measured by their
current ratios.
d. The transactions would lower both firm' financial strength as measured by their current
ratios.
e. The transactions would improve both firms' financial strength as measured by their current
ratios.
ANSWER: b
RATIONALE: The key here is to recognize that if the CR is less than 1.0, then a given increase to both current
assets and current liabilities will increase the CR, while the reverse will hold if the initial CR is
greater than 1.0. Thus, the transactions would make Risco look stronger but Safeco look weaker.
Here's an illustration:
Safeco:
Original Plus New Old New
CA/CL $10 CA/CL CR CR
2.00 1.50 CR falls because initial CR is greater than 1.0
Risco:
Original Plus New Old New
CA/CL $10 CA/CL CR CR
0.50 0.67 CR rises because initial CR is less than 1.0
All of the statements except b are incorrect.

82. Companies HD and LD have the same total assets, sales, operating costs, and tax rates, and they pay the
same interest rate on their debt. Both firms finance using only debt and common equity and total assets equal
total invested capital. However, company HD has a higher total debt to total capital ratio. Which of the
following statements is CORRECT?
a. Given this information, LD must have the higher ROE.
b. Company LD has a higher basic earning power ratio (BEP).
c. Company HD has a higher basic earning power ratio (BEP).
d. If the interest rate the companies pay on their debt is more than their basic earning power
(BEP), then Company HD will have the higher ROE.
e. If the interest rate the companies pay on their debt is less than their basic earning power
(BEP), then Company HD will have the higher ROE.
ANSWER: e
RATIONALE: The companies have the same EBIT and assets, hence the same BEP ratio. If the interest rate is
less than the BEP, then using more debt will raise the ROE. Therefore, statement e is correct.
The others are all incorrect.

Multiple Choice: Problems

85. Beranek Corp has $720,000 of assets (which equal total invested capital), and it uses no debt—it is financed
only with common equity. The new CFO wants to employ enough debt to raise the total debt to total capital
ratio to 40%, using the proceeds from borrowing to buy back common stock at its book value. How much must
the firm borrow to achieve the target debt ratio?
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 a. $273,600
b. $288,000
c. $302,400
d. $317,520
e. $333,396
ANSWER: b
RATIONALE: Total assets = Total invested capital $720,000
Target debt to total capital ratio 40%
Debt to achieve target ratio = Amount borrowed = Target % × Invested
= $288,000
capital

86. Ajax Corp's sales last year were $435,000, its operating costs were $362,500, and its interest charges were
$12,500. What was the firm's times-interest-earned (TIE) ratio?
a. 4.72
b. 4.97
c. 5.23
d. 5.51
e. 5.80
ANSWER: e
RATIONALE: Sales $435,000
Operating costs $362,500
Operating income (EBIT) $ 72,500
Interest charges $ 12,500
TIE ratio = EBIT/Interest = 5.80

87. Royce Corp's sales last year were $280,000, and its net income was $23,000. What was its profit margin?
a. 7.41%
b. 7.80%
c. 8.21%
d. 8.63%
e. 9.06%
ANSWER: c
RATIONALE: Sales $280,000
Net income $23,000
Profit margin = NI/Sales 8.21%

89. X-1 Corp's total assets at the end of last year were $405,000 and its EBIT was 52,500. What was its basic
earning power (BEP) ratio?
a. 11.70%
b. 12.31%
c. 12.96%
d. 13.61%
e. 14.29%
ANSWER: c
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RATIONALE: Total assets $405,000
EBIT $52,500
BEP = EBIT/Assets = 12.96%

91. Your sister is thinking about starting a new business. The company would require $375,000 of assets, and it
would be financed entirely with common stock. She will go forward only if she thinks the firm can provide a
13.5% return on the invested capital, which means that the firm must have an ROE of 13.5%. How much net
income must be expected to warrant starting the business?
a. $41,234
b. $43,405
c. $45,689
d. $48,094
e. $50,625
ANSWER: e
RATIONALE: Assets = Equity $375,000
Target ROE 13.5%
Required net income = Target ROE × Equity = $50,625

92. Herring Corporation has operating income of $225,000 and a 40% tax rate. The firm has short-term debt of
$120,000, long-term debt of $330,000, and common equity of $450,000. What is its return on invested capital?
a. 13.75%
b. 14.33%
c. 15.00%
d. 16.25%
e. 17.10%
ANSWER: c
RATIONALE: EBIT $225,000
Tax rate 40%
Short-term debt $120,000
Long-term debt $330,000
Common equity $450,000

ROIC = [EBIT(1 – T)]/(STD + LTD + E) 15%

96. Meyer Inc's total invested capital is $625,000, and its total debt outstanding is $185,000. The new CFO
wants to establish a total debt to total capital ratio of 55%. The size of the firm will not change. How much debt
must the company add or subtract to achieve the target debt to capital ratio?
a. $158,750
b. $166,688
c. $175,022
d. $183,773
e. $192,962
ANSWER: a
RATIONALE: Total invested capital $625,000
Old debt $185,000
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 Target debt to capital ratio 55%
Target amount of debt = Target debt % × Total invested capital = $343,750
Change in amount of debt outstanding = Target debt − Old debt = $158,750

98. Garcia Industries has sales of $200,000 and accounts receivable of $18,500, and it gives its customers 25
days to pay. The industry average DSO is 27 days, based on a 365-day year. If the company changes its credit
and collection policy sufficiently to cause its DSO to fall to the industry average, and if it earns 8.0% on any
cash freed-up by this change, how would that affect its net income, assuming other things are held constant?
a. $241.45
b. $254.16
c. $267.54
d. $281.62
e. $296.44
ANSWER: e
RATIONALE: Rate of return on cash generated 8.0%
Sales $200,000
A/R $18,500
Days in Year 365
Sales/day = Sales/365 = $547.95
Company DSO = Receivables/Sales per day = 33.8
Industry DSO 27.0
Difference = Company DSO − Industry DSO = 6.8
Cash flow from reducing the DSO = Difference × Sales/day = $3,705.48
Additional Net Income = Return on cash × Added cash flow = $296.44

Alternative Calculation:
A/R at industry DSO $14,794.52
Change in A/R $3,705.48
Additional Net Income $296.44

101. Wie Corp's sales last year were $315,000, and its year-end total assets were $355,000. The average firm in
the industry has a total assets turnover ratio (TATO) of 2.4. The firm's new CFO believes the firm has excess
assets that can be sold so as to bring the TATO down to the industry average without affecting sales. By how
much must the assets be reduced to bring the TATO to the industry average, holding sales constant?
a. $201,934
b. $212,563
c. $223,750
d. $234,938
e. $246,684
ANSWER: c
RATIONALE: Sales $315,000
Actual total assets $355,000
Target TATO = Sales/Total assets = 2.40
Target assets = Sales/Target TATO = $131,250
Asset reduction = Actual assets − Target assets = $223,750

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103. Duffert Industries has total assets of $1,000,000 and total current liabilities (consisting only of accounts
payable and accruals) of $125,000. Duffert finances using only long-term debt and common equity. The interest
rate on its debt is 8% and its tax rate is 40%. The firm's basic earning power ratio is 15% and its debt-to capital
rate is 40%. What are Duffert's ROE and ROIC?
a. 12.00%; 10.29%
b. 12.57%; 10.29%
c. 13.94%; 9.86%
d. 13.94%; 10.29%
e. 13.94%; 11.50%
ANSWER: d
RATIONALE: Total assets $1,000,000

Balance sheet:
Current liabilities $125,000
Debt 350,000
Common equity 525,000
Total liabilities $1,000,000

D/(D + E) = 0.4
D/($1,000,000 –
$125,000,000) = 0.4
D = $350,000

Now calculate EBIT:

BEP = 0.15 = EBIT/TA = EBIT/$1,000,000
EBIT = $150,000

Calculate ROIC: ROIC = [EBIT(1 – T)]/(D + E) = [$150,000(0.6)]/$875,000 = 10.29%

Now determine net income from income statement:

EBIT $150,000
Interest 28,000 (0.08 × $350,000)
EBT $122,000
Taxes (40%) 48,800
NI $ 73,200

ROE = NI/E = $73,200/$525,000 = 13.94%

104. Chang Corp. has $375,000 of assets, and it uses only common equity capital (zero debt). Its sales for the
last year were $595,000, and its net income was $25,000. Stockholders recently voted in a new management
team that has promised to lower costs and get the return on equity up to 15.0%. What profit margin would the
firm need in order to achieve the 15% ROE, holding everything else constant?
a. 9.45%
b. 9.93%
c. 10.42%
d. 10.94%
e. 11.49%
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ANSWER: a
RATIONALE: Total assets = Equity because zero debt $375,000
Sales $595,000
Net income $25,000
Target ROE 15.00%
Net income req'd to achieve target ROE = Target ROE × Equity = $56,250
Profit margin needed to achieve target ROE = NI/Sales = 9.45%

105. Last year Ann Arbor Corp had $155,000 of assets (which equals total invested capital), $305,000 of sales,
$20,000 of net income, and a debt-to-total-capital ratio of 37.5%. The new CFO believes a new computer
program will enable it to reduce costs and thus raise net income to $33,000. The firm finances using only debt
and common equity. Assets, total invested capital, sales, and the debt to capital ratio would not be affected. By
how much would the cost reduction improve the ROE?
a. 11.51%
b. 12.11%
c. 12.75%
d. 13.42%
e. 14.09%
ANSWER: d
RATIONALE: Assets = Total invested capital $155,000
Debt to total capital ratio 37.5%
Debt = Capital × Debt % = $58,125
Equity = Assets − Debt = $96,875
Sales $305,000
Old net income $20,000
New net income $33,000
New ROE = New NI/Equity = 34.065%
Old ROE = Old NI/Equity = 20.645%
Increase in ROE = New ROE − Old ROE = 13.42%

106. Brookman Inc's latest EPS was $2.75, its book value per share was $22.75, it had 315,000 shares
outstanding, and its debt/total invested capital ratio was 44%. The firm finances using only debt and common
equity and its total assets equal total invested capital. How much debt was outstanding?
a. $4,586,179
b. $4,827,557
c. $5,081,639
d. $5,349,094
e. $5,630,625
ANSWER: e
RATIONALE: EPS $2.75
BVPS $22.75
Shares outstanding 315,000
Debt to total capital ratio 44.0%
Total equity = Shares outstanding × BVPS = $7,166,250
Total assets = Total equity/(1 − Debt to total capital ratio) = $12,796,875
Total debt = Total assets − Equity = $5,630,625
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107. Last year Harrington Inc. had sales of $325,000 and a net income of $19,000, and its year-end assets were
$250,000. The firm's total-debt-to-total-capital ratio was 45.0%. The firm finances using only debt and common
equity and its total assets equal total invested capital. Based on the DuPont equation, what was the ROE?
a. 13.82%
b. 14.51%
c. 15.23%
d. 16.00%
e. 16.80%
ANSWER: a
RATIONALE: Sales $325,000
Assets = Total invested capital $250,000
Net income $19,000
Debt to total capital ratio 45.0%
Debt = Debt % × Capital = $112,500
Equity = Assets − Debt = $137,500
Profit margin = NI/Sales = 5.85%
TATO = Sales/Assets = 1.30
Equity multiplier = Assets/Equity = 1.82
ROE 13.82%

108. Last year Rennie Industries had sales of $305,000, assets of $175,000 (which equals total invested capital),
a profit margin of 5.3%, and an equity multiplier of 1.2. The CFO believes that the company could reduce its
assets by $51,000 without affecting either sales or costs. The firm finances using only debt and common equity.
Had it reduced its assets by this amount, and had the debt/total invested capital ratio, sales, and costs remained
constant, how much would the ROE have changed?
a. 4.10%
b. 4.56%
c. 5.01%
d. 5.52%
e. 6.07%
ANSWER: b
RATIONALE: Old New
Sales $305,000 $305,000
Original assets = Original capital $175,000
Reduction in assets = Reduction in capital $ 51,000
New assets = Old assets − Reduction = $124,000
TATO = Sales/Assets = 1.74 2.46
Profit margin 5.30% 5.30%
Equity multiplier 1.20 1.20
ROE = PM × TATO × Eq. multiplier = 11.08% 15.64%
Change in ROE 4.56%

109. Last year Blease Inc had a total assets turnover of 1.33 and an equity multiplier of 1.75. Its sales were
$295,000 and its net income was $10,600. The firm finances using only debt and common equity and its total
assets equal total invested capital. The CFO believes that the company could have operated more efficiently,
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lowered its costs, and increased its net income by $10,250 without changing its sales, assets, or capital structure.
Had it cut costs and increased its net income by this amount, how much would the ROE have changed?
a. 6.55%
b. 7.28%
c. 8.09%
d. 8.90%
e. 9.79%
ANSWER: c
RATIONALE: Old New
Sales $295,000 $295,000
Original net income $ 10,600 $ 10,600
Increase in net income $ 0 $ 10,250
New net income $ 10,600 $ 20,850
Profit margin = NI/Sales = 3.59% 7.07%
TATO 1.33 1.33
Equity multiplier 1.75 1.75
ROE = PM × TATO × Eq. multiplier = 8.36% 16.45%
Change in ROE 8.09%

111. Last year Kruse Corp had $305,000 of assets (which is equal to its total invested capital), $403,000 of
sales, $28,250 of net income, and a debt-to-total-capital ratio of 39%. The new CFO believes the firm has
excessive fixed assets and inventory that could be sold, enabling it to reduce its total assets and total invested
capital to $252,500. The firm finances using only debt and common equity. Sales, costs, and net income would
not be affected, and the firm would maintain the same capital structure (but with less total debt). By how much
would the reduction in assets improve the ROE?
a. 2.85%
b. 3.00%
c. 3.16%
d. 3.31%
e. 3.48%
ANSWER: c
RATIONALE: Original New
Assets = Total invested capital $305,000 $252,500
Sales $403,000 $403,000
Net income $28,250 $28,250
Debt to capital ratio 39.00% 39.00%
Debt = Capital × debt % = $118,950 $98,475
Equity = Assets − Debt = $186,050 $154,025
ROE = NI/Equity = 15.184% 18.341%
Increase in ROE 3.16%

113. Last year Hamdi Corp. had sales of $500,000, operating costs of $450,000, and year-end assets (which is
equal to its total invested capital) of $395,000. The debt-to-total-capital ratio was 17%, the interest rate on the
debt was 7.5%, and the firm's tax rate was 35%. The new CFO wants to see how the ROE would have been
affected if the firm had used a 50% debt-to-total-capital ratio. Assume that sales, operating costs, total assets,
total invested capital, and the tax rate would not be affected, but the interest rate would rise to 8.0%. By how
much would the ROE change in response to the change in the capital structure?
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 a. 1.71%
b. 1.90%
c. 2.11%
d. 2.34%
e. 2.58%
ANSWER: d
RATIONALE: Old New
Interest rate 7.5% 8.0%
Tax rate 35% 35%
Assets = Total capital $395,000 $395,000
Debt-to-capital ratio 17% 50%
Debt = Capital × Debt ratio = $ 67,150 $197,500
Equity = Assets − Debt = $327,850 $197,500

Sales $500,000 $500,000

Operating costs 450,000 450,000
EBIT = Sales − Operating costs = $ 50,000 $ 50,000
Interest paid = Interest rate × Debt = 5,036 15,800
Taxable income $ 44,964 $ 34,200
Taxes 15,737 11,970
Net income $ 29,226 $ 22,230
ROE 8.91% 11.26%
Change in ROE 2.34%

114. Quigley Inc. is considering two financial plans for the coming year. Management expects sales to be
$300,000, operating costs to be $265,000, assets (which is equal to its total invested capital) to be $200,000, and
its tax rate to be 35%. Under Plan A it would finance the firm using 25% debt and 75% common equity. The
interest rate on the debt would be 8.8%, but under a contract with existing bondholders the TIE ratio would
have to be maintained at or above 4.0. Under Plan B, the maximum debt that met the TIE constraint would be
employed. Assuming that sales, operating costs, assets, total invested capital, the interest rate, and the tax rate
would all remain constant, by how much would the ROE change in response to the change in the capital
structure?
a. 3.71%
b. 4.08%
c. 4.48%
d. 4.93%
e. 5.18%
ANSWER: a
RATIONALE: Work down the Plan A column, find the Max Debt, then use it to complete Plan B and the ROEs.
Plan A Plan B
Interest rate 8.80% 8.80%
Tax rate 35% 35%
Assets = Total capital $200,000 $200,000
Debt ratio: Plan A given, Plan B calculated 25% 49.7%
Debt $ 50,000 $ 99,432
Equity $150,000 $100,568

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 Sales Constant $300,000 $300,000
Operating costs Constant 265,000 265,000
EBIT Constant $ 35,000 $ 35,000
Interest 4,400 8,750
Taxable income $ 30,600 $ 26,250
Taxes 10,710 9,188
Net income $ 19,890 $ 17,063
ROE = NI/Equity = 13.26% 16.97%
TIE = EBIT/Interest = 7.95
Minimum TIE 4.00
$ of Interest consistent with minimum TIE
= EBIT/Min. TIE = $8,750
Max debt = Interest/interest rate = $99,432
Change in ROE 3.71%

Problems:
1.

Answer:
4-22 1. Total assets = Total liabilities and equity = $300,000.

2. Sales = (1.5)(Total assets) = (1.5)($300,000) = $450,000.

3. Accounts receivable = (Sales/365)(DSO) = ($450,000/365)(36.5) = $45,000.

4. Inventories = Sales/5 = $450,000/5 = $90,000.

5. Fixed assets = Sales/3 = $450,000/3 = $150,000.

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6. Cash + Accounts receivable + Inventories + Fixed assets = Total assets
Cash + $45,000 + $90,000 + $150,000 = $300,000
Cash + $285,000 = $300,000
Cash = $15,000.

7. Current liabilities = (Cash + Accounts receivable + Inventories)/2

= ($15,000 + $45,000 + $90,000)/2
= $75,000.

8. Common stock = Total liabilitie s – Current liabilities – Long-term debt – Retained earnings
and equity
= $300,000 – $75,000 – $60,000 – $97,500 = $67,500.

9. Cost of goods sold = (Sales)(1 – 0.25) = ($450,000)(0.75) = $337,500.

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